Building on leased land results in separate ownership of that building and the land. The two owners, one of the land, and one of the improvement come together in one investment parcel. In this situation, the landowner wants someone to develop the land but still wants to continue in ownership. The developer prefers to lease rather than buy the property.
One owner wants the security of owning the land with a good lease to the owner of the improvement. The owner of the building puts up less money since the ownership of land is not part of the expenses in the development.
Benefits To The Lessor
An example could be the developer of upscale homes who wants to keep the ownership of the land as an investment. Using the land lease can widen his market by reducing the house’s purchase price. In certain parts of the country, the value of the land equals or surpasses the value of the house. Leasing the land can cut the purchase price nearly in half. With this type of land lease, there is usually a provision for a rent increase halfway through the lease term in accordance with the results of a reappraisal of the land.
Benefits To The Lessee
The land lease results in the following benefits for a builder or developer:
- He/she can acquire a valuable parcel of land with very little cash investment.
- This leasehold that is acquired is an asset that can increase in value, and then could be used as security for a loan or sold for a profit.
- The rental payments are fully deductible by the lessee.
- With a subordinated land lease, the lessee-developer gets the equivalent of a 100% loan on the land.
The Term of the Lease
Usually, a developer/lessee will attempt to get the longest possible term in the lease because the shorter-term land lease would have a smaller market for resale. A long-term land lease is generally a net lease under which the lessee pays the carrying costs, including real estate taxes.
When the land rental is a fixed amount, it is a percentage of the fair market value of the land when the lease is executed. This lease will often include a provision for a reappraisal of the land at fixed intervals, with new adjustments in the rent. In some cases, for instance, with a shopping center, the landowner might demand a share of the percentage rentals over and above the fixed land rent. (Much of the income in the shopping center will come from percentage overages from the sub-lessees.)
Subordination Of The Lease
If the owner of the land will not subordinate the lease to a leasehold mortgage, the developer should get a reduction in rent because the unsubordination will cause his financing to be more expensive. Subordination could be the most important item in the terms of the lease. Even a short subordinated lease might be better than a longer unsubordinated lease, even though the longer lease is more salable.
The landowner may or may not allow his interest as owner/lessor to be subordinated to the interest of a leasehold mortgagee. When there is a subordination to the mortgage, the lender, in effect, gets a fee mortgage on the land rather than a leasehold mortgage.
When the lease is unsubordinated, the landowner/lessor has first rights over the lender in case the lessee-mortgagor should default. With these terms, the lessee could find that he cannot get a loan, or can get one only at a higher rate of interest. Without the subordination, the mortgage is, in effect, a second lien since the lessor’s claim on the rents takes precedence over payments on the mortgage.
The objections of an owner to subordination of the lease could be as follows:
- He could lose the property if the lessee defaults on the leasehold mortgage.
- Subordination reduces his possibility of mortgaging his fee interest in the land, which would be a logical move for the lessor. If the subordination were part of the terms, the landowner would record his right to receive any notice of default from the leasehold mortgagee and the right to cure the default. The expense would be reimbursed to the owner by adding the amount to the lessee’s rent obligation.